C Corp and S Corp Differences: The Hidden Consequences of Choosing Wrong in 2025

Small business owners and entrepreneurs in California consistently misjudge the real impact of picking the wrong corporation type. The comfort of forming a corporation often blinds people to irreversible tax disadvantages. For the 2025 tax year, making the correct entity choice is the difference between stacking up legal savings and losing tens of thousands each year to avoidable taxes and unnecessary complexity.

Quick Answer: S Corp vs C Corp — What Actually Changes in 2025?

For the 2025 tax year, the core difference is how your profits get taxed. C Corp and S Corp differences hinge on the way income is taxed and distributed: C Corps face double taxation (once at the corporation level and again when owners are paid dividends), while S Corps pass through profit directly to the owners’ personal returns, avoiding federal double tax. California taxes both entities—S Corp income flows to the individual and faces an annual 1.5% state franchise tax (minimum $800), while C Corps face both the franchise tax and a state corporate tax (8.84%). Your salary strategy, how you pull money from the business, and exposure to IRS audits all change based on entity choice.

Understanding How C Corp and S Corp Differences Affect Your Taxes

There’s a reason “Should I be an S Corp?” is one of the top questions for business owners in California. A C Corporation is a separate tax-paying entity and pays federal income tax on its profits before any distributions. When those profits are then paid to you as dividends, you pay tax again on your personal return. In contrast, an S Corporation is a pass-through—profits aren’t taxed at the entity level federally; instead, they hit your personal tax return (often at a lower effective rate), and only your salary is subject to payroll taxes.

Example: Let’s compare Jesse, a solo tech consultant whose LLC earns $200,000 net in 2025. As a C Corp, his company pays about $17,680 in California corporate tax (8.84% on all earnings) plus the $800 franchise tax. If Jesse tries to pull $120,000 as salary, he will also have FICA payroll taxes (Social Security and Medicare) both on his W-2 and via the employer portion. On another $60,000 taken as a dividend, those funds are taxed again personally (potentially 15% qualified dividend rate federally). The result? Effective federal/state tax rate approaches 37%+ before factoring in payroll taxes.

As an S Corp, Jesse can pay himself a “reasonable” salary (let’s say $100,000) and take the rest as a distribution, which avoids Social Security and Medicare tax. The S Corp pays the annual 1.5% CA franchise tax plus payroll tax only on the salary portion. His effective tax rate could drop by $8,000–$14,000 year-over-year.

Pro Tip: The true S Corp benefit is salary vs distribution. You only pay payroll tax on your salary—distributions can be taken free of Social Security and Medicare. But lowballing your salary can trigger an audit.

KDA Case Study: S Corp Rescue for a California Consultant

Rachel is a freelance marketing strategist earning $175,000 in net income through her single-member LLC. Her past accountant suggested a C Corp, thinking she’d “look bigger” for clients. For three years, Rachel lost nearly $14,700 annually to double-taxation—CA and federal. KDA ran a full-entity analysis, converted her to an S Corp for the 2025 tax year, set up compliant payroll, and restructured owner draws. She took $90,000 as salary and $65,000 as yearly distributions. Rachel’s total payroll tax dropped by $9,955 after the switch, and her corporate tax bill shrank by over 40%. For a $2,950 advisory fee, her first-year ROI was over 4.4x (with permanent annual savings going forward).

Ready to see how we can help you? Explore more success stories on our case studies page to discover proven strategies that have saved our clients thousands in taxes.

The Decision Trap: What the IRS Doesn’t Emphasize About Entity Choice

Most business owners just want to pay themselves the “right” way and avoid audit notices. The IRS, however, doesn’t spell out the silent penalties of the C Corp for mid-sized service businesses in California. If you’re not aiming for outside investors or future fundraising, the C Corp’s double tax destroys your profit margin. The “corporate image” myth costs more than it’s worth.

For instance, a boutique law firm netting $350,000 in annual profit would lose roughly $23,352 to CA C Corp tax (8.84%), pay another $800 flat franchise tax, and if profits are paid out as dividends, the firm’s two partners are hit at the personal tax level. By opting into S Corp status, they would face a $5,250 franchise tax (only 1.5%) and could split payroll/distributions, reducing payroll taxes by as much as $10,400 year over year. See official details under IRS S Corporation guidance.

How California’s Rules Bend (and Break) Standard Federal Tax Logic

California throws a wrench into standard S Corp vs C Corp math. Unlike many states, it taxes S Corporations at a flat 1.5% on net income (1.5% of all California-source profit, not just what’s distributed), plus the $800 annual franchise minimum. For C Corps, it’s 8.84% of net income, which is always steeper unless you retain profits indefinitely (not realistic for most service firms or solo LLCs).

If your business operates in or out of California, S Corp tax rarely gets wiped away. Nonresident S Corp owners in other states may owe tax on their CA-source share. If you incorporate elsewhere but work in CA, you’re still subject to these rules. Ignoring the California minimums can trigger late penalties and back-interest, as spelled out in the CA Franchise Tax Board FAQ.

Will S Corp or C Corp Status Trigger an IRS or FTB Audit?

The short answer: choosing S Corp won’t automatically trigger an audit, but paying yourself too low or too high a salary will. The IRS expects S Corp owners to take a “reasonable” wage. Set salary too low, and you’ll draw attention—especially in high-wage California professions like law, consulting, medicine, and tech. C Corp owners must treat dividends separately from salary, and improper classification can backfire (double tax plus audit penalties).

The FTB (California’s tax authority) also looks for S Corps operating as sole proprietors—especially if they see unexplained distributions or unexplained 1099s. Audit letters commonly cite underpayment of the annual franchise tax or neglecting multi-state allocation rules. For more, see IRS Form 1120-S instructions for S Corps and Form 1120 for C Corps.

Red Flag Alert: S Corp distributions with no payroll typically trigger IRS questions. C Corp salary over $100,000 without payroll tax withholding triggers both IRS and FTB inquiries. Verify your salary split before filing.

Follow-Up: Is Switching from C Corp to S Corp Easy?

Not as easy as you think. A C Corp must file Form 2553 by March 15 to elect S Corp status for the current tax year. After initial incorporation, switching requires both shareholder and state approval, IRS sign-off, and clean accounting records. KDA has completed hundreds of successful conversions—but intakes always include compliance clean-up, form amendments, and FTB coordination. If you’ve already paid out dividends as a C Corp, you can’t retroactively reclassify them as S Corp distributions.

What Are the ‘Hidden’ Costs of Each Choice?

The C Corp structure can make sense for startups chasing outside financing, multi-state manufacturers, or companies planning to go public. For everyone else—especially service businesses and solo professionals—S Corp’s payroll flexibility and single-layer tax wins out. But don’t forget S Corps come with extra bookkeeping, annual meeting documentation, and salary monitoring. If you overdo distributions (or underpay yourself), you open the door to IRS trouble.

If you’re torn between S Corp and C Corp but plan on retaining earnings to avoid personal tax, remember: California still takes its 8.84% cut. Plus, IRS rules for “accumulated earnings tax” (see IRS publication) can penalize you for stockpiling too much profit in the company.

Bottom Line: Which Entity Is Right for You?

In 2025, service-based businesses and professionals almost always come out ahead with an S Corp structure—unless you fit a very narrow C Corp profile (venture-backed, IPO, foreign shareholders). Any LLC making over $80,000 in net profit should revisit the S Corp election to cut payroll taxes and dodge double-tax on distributions.

For a complete breakdown of S Corp strategies, see our comprehensive S Corp tax guide.

• W-2 Employees: S Corp usually a no-go without side business income.
• 1099 Contractors: S Corp can transform your tax bill if profit >$80,000.
• LLC Owners: S Corp is the fastest way to shred unnecessary payroll tax.
• Real Estate Investors: C Corp rarely makes sense—ask before converting.

FAQ

What if I’m just starting out?

If your profit’s under $60,000/year, S Corp status often isn’t worth it given added payroll and admin cost. Revisit once net income grows.

Can I have foreign owners and stay elect S Corp?

No. S Corps can’t have nonresident alien shareholders; you’d need a C Corp or alternative entity structure. See IRS S Corporation eligibility.

What taxes do S Corp and C Corp pay in California in 2025?

S Corps pay 1.5% CA tax (minimum $800); C Corps pay 8.84% plus $800 minimum annual tax—this is on top of federal taxes and any payroll tax owed.

This information is current as of 10/16/2025. Tax laws change frequently. Verify updates with the IRS or FTB if reading this later.

Book Your Entity Assessment

Paying too much in taxes because you chose the wrong entity? Our team uncovers an average $12,400 in savings for California business owners by optimizing the S Corp/C Corp split. Book your personalized tax entity consultation now and claim your savings for 2025.